The National Flood Insurance Program: Two Major Problem Areas
March 2006
It is already apparent that one of the most
heavily litigated issues to arise out of the 2005 hurricane season will be cause
of loss, particularly as it relates to flood exclusions in homeowners and other
form policies and flood sublimits in more sophisticated commercial policies.
by Jay M.
Levin
Reed Smith
This litigation includes the lawsuit filed by Mississippi Attorney General
Jim Hood, seeking to avoid enforcement of flood exclusions in homeowner's policies.
It also includes litigation in Louisiana seeking to determine that much of the
contended "flood" damage was actually caused by improper engineering and construction
of levees or negligent damage to wetlands, reducing flood protection for New
Orleans. Separately, individual policyholders with substantial claims have,
or soon will, file lawsuits to determine the scope of first-party coverage for
their 2005 hurricane losses. In the final analysis, all of this litigation is
driven by one factor: inadequate or unclear insurance coverage, particularly
as it relates to flood insurance.
Risk managers need to understand the precise parameters of their insurance
coverage for flood and consider how both National Flood Insurance Program (NFIP)
coverage and commercial coverage will respond in the event of different types
of disaster. This article focuses on two issues arising under NFIP policies:
The draconian effect of missing policy deadlines for filing a proof of loss
and the lack of "bad faith" remedy to protect against claims handling abuses.
The Loss Notice Conundrum
The first place to start with flood insurance in flood and hurricane-prone
areas is the NFIP, a statutorily mandated program which provides federal flood
insurance protection for properties in certain flood zones. The NFIP is administered
by the Federal Emergency Management Agency (FEMA) under the National Flood Insurance
Act. The terms of standard flood insurance policies are dictated by FEMA, and
payments on claims arising under such policies are ultimately paid by the federal
treasury. Insurers writing standard flood insurance policies under the NFIP
are called "write your own insurers." All losses and all administrative expenses
they incur are paid by the NFIP, and ultimately the money comes out of the federal
budget.
NFIP policies are, of course, very useful, particularly where other flood
insurance is not available. In addition to providing stand-alone flood coverage,
they can act as primary flood coverage for commercial risks and allow a standard
commercial property policy to provide excess flood coverage. This makes flood
coverage from standard markets (as opposed to NFIP coverage) both cheaper and
more readily available.
However, policyholders must be aware of several key issues. First, as with
other types of property policies, standard flood insurance policies require
the insureds to file a proof of loss within 60 days. However, unlike proof of
loss requirements under standard policies, courts strictly enforce the 60-day
requirement and hold that failure timely to file a proof of loss complying with
the regulatory requirements is a valid basis for denying a claim under federal
flood policy. See, e.g., Wright v. Allstate Ins.,
415 F.3d 384 (5th Cir. 2005).
In contrast, under standard commercial policies, almost every state requires
an insurer to prove prejudice before being allowed to avoid coverage because
the insured failed timely to file a sufficient proof of loss. Indeed, in the
case of NFIP policies, even if the insured relies on statements by a write your
own insurer's adjuster indicating that the proof of loss requirement will not
be strictly enforced, failure to comply with that requirement may lead to forfeiture
of coverage. Wright, 415 F.3d at 388 (citing Dawkins v. Witt, 318 F.3d 606 (4th Cir.
2003)).
The circumstances in Wright are truly egregious.
After Tropical Storm Allison struck Houston in 2001, Dr. Wright filed a claim
under his standard flood insurance policy, issued through Allstate. The Allstate
adjuster calculated covered damage at $12,580.04. Dr. Wright's public adjuster
estimated the loss, after deducting damage unrelated to flood, at $125,840.23.
The public adjuster and Allstate's adjuster were not able to agree on the amount
of loss and Dr. Wright refused to sign Allstate's proposed proof of loss. Instead,
he submitted his own proof of loss which did not include all of the information
required by FEMA regulations.
Allstate, not its outside adjuster, responded by stating "We are accepting
this proof in compliance with the policy conditions concerning the filing of
a Proof of Loss." The letter expressly reserved all other rights and defenses
available under the policy. The public adjuster sent three letters to Allstate
trying to initiate settlement negotiations. Allstate's response, received only
after the deadline for filing a proof of loss had passed, rejected Dr. Wright's
claim on the grounds that he failed to cooperate as required by the terms and
conditions of the policy and failed to file an adequate proof of loss within
the proper time. Dr. Wright filed suit, and the district court eventually determined
that Allstate was equitably estopped from denying the claim based on the failure
to timely file a proper proof of loss.
The U.S. Court of Appeals for the Fifth Circuit reversed, finding that, because
NFIP insurance proceeds are funded by the federal treasury, equitable estoppel
is generally not available. Indeed, citing U.S. Supreme Court precedent, the
Fifth Circuit held that: "Where federal funds are implicated, the person seeking
those funds is obligated to familiarize themselves with the legal requirements
for receipt of such funds." Because the policy terms were dictated by FEMA,
they could not be waived or modified by Allstate. Therefore, the Allstate employee
was not authorized to waive the requirement that a proof of loss be timely filed
with certain specific information, and Dr. Wright's claim was barred.
No Bad Faith Remedy
Federal flood insurance presents another significant problem. Write your
own insurers are not subject to bad faith liability under state law. Thus, in Wright, the court specifically held that state
law tort claims arising from claims adjustment activities, i.e., bad faith claims
handling, were preempted by the National Flood Insurance Act. Following precedent
from the Third and Sixth Circuits, C.E.R. 1988, Inc.
v. Aetna Cas. & Surety, 386 F.3d 263 (3rd Cir. 2004); Gibson v. American Bankers, 269 F.3d 943 (6th
Cir. 2002), the Fifth Circuit held in Wright that the NFIP was conceived to achieve national policies, and the federal government
participates extensively both financially and in a supervisory capacity. The
Fifth Circuit noted with approval the Third Circuit's statement that a central
purpose of the NFIP was to reduce financial pressures on federal flood relief
efforts and that state law tort claims against write your own insurers increase
the cost to the federal government and reduced the efficiency of the program.
The Fifth Circuit also looked to FEMA regulations which amended the language
of the standard flood insurance policy to state: "This policy and all disputes
arising from the handling of any claim under the policy are governed exclusively
by the flood insurance regulations issued by FEMA, the National Flood Insurance
Act of 1968….and federal common law." 415 F.3d at 390 (ellipses in original).
The court noted that this policy language might provide a separate and sufficient
basis for preemption.
Interestingly, the Fifth Circuit remanded for determination of why the district
court had denied Dr. Wright's motion to amend his complaint to add federal common
law claims for fraud and negligent misrepresentation. That holding left open
the possibility of federal common law bad faith claims. The viability of such
claims is, however, open to some question. In Scritchfield
v. Mutual of Omaha Ins., 341 F. Supp. 2d 675 (E.D. Tex. 2004), the court
was faced with the question of whether insurance bad faith claims are available
under federal common law in the context of federal flood insurance. After analyzing
the National Flood Insurance Act, the court decided that there is nothing in
the statute indicating that Congress intended to create private tort actions
under the statute.
The court noted that the Act does permit policyholders to sue for breach
of contract if they are dissatisfied with the amount of claim payments, but
there is nothing in the legislative history suggesting a statutory cause of
action for negligence or consequential damages. In accordance with this analysis,
the court held that there was no federal common law right to bad faith. Therefore,
to the extent federal flood insurance is available and purchased, write your
own insurers have a virtual cart blanche to handle claims any way they see fit, usually to the detriment of the policyholder.
Conclusion
While NFIP coverage can be an important part of an insurance program for
businesses operating in flood and hurricane-prone areas, policyholders should
take careful note of all policy terms and conditions. Such terms and conditions
should be carefully followed. Failure to do so can lead to forfeiture of coverage.
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